Friday, January 12, 2007

On Options

Well, it was another wreck of a day for da bears (new high on the Dow, once again), so.......let's talk about something else, shall we? Seriously, one of the most frequent requests I have been getting in the comments section has been to talk a bit about options. So here we go.

Considering the market's behavior lately, let's make this a happy story and focus on a call option. In particular, a call option for a stock I suggested way back in an October 6, 2006 post. The stock was Immucor, symbol BLUD.


At the time, the stock was at about $25. Now let's suppose you had so much faith in this chart that you didn't just want to buy the stock, you wanted to buy the call option (in order to leverage your investment and possibly enjoy great percentage gains).

Well, let's slow down for just a minute and do the most important thing first: figure out a stop-loss price. In other words, figure out at what price we would consider our speculation incorrect. In the case of BLUD, the deepest point of the most recent dip in this chart was at $21.57, about $4 less than its current price. So we decide that if the price ever dips below this level, we will close out our position at once.


Next we have to pick an option - - we'll want a call option, of course, since we're bullish on the stock. I typically look for a number of properties in the option I choose:


  • I'd like it to be a little in the money; so in this case, we'd want a $25 call, since the stock is a little over that amount

  • I'd like the expiration to be at least two or three months down the road. If you get the "front month", the time decay will eat you alive. But if you buy an option that's a year down the road, the movement in the stock will have a very dampened effect on the price of the option. So right now it's January, and I'd be looking at Marches or Aprils (at the time of the BLUD suggestion, a January option would have been appropriate).

  • I want to see relatively beefy volume and open interest. It's not easy to find with options (except for huge ones like the S&P 500).

  • I want to see a bid/ask spread that's not big enough to drive a truck through. If an option is bid 5.30, ask 6.50, I'm not interested. Focusing on rule (3) will help get you away from overly fat spreads.

So, for instance, here's a chunk of an options screen showing the S&P options; the one I've highlighted is interesting since its volume and open interest stand out above the others, plus, it's in-the-money.


Once the order is placed, I immediately want to get a contingent order placed. This means that if the stock goes above (in the case of a put) or below (in the case of a call) a certain price, a market order will be immediately placed to close that position at the best available price.


Those are pretty much the steps. Once they are in place, one of several things can happen. The stock can move in the direction you anticipated, which will benefit the option even more. Or the stock can move against you, pushing past your stop price, and closing the position at a loss. Or the stock can just meander along, which isn't something you can tolerate for long because the option will expire at some point!


Now let's see the happy ending to this story. BLUD went up about 30% since the suggestion back in October. But the option went up hundreds of percent! That's the beauty of leverage. Now, I admit, this is a fairly idealized example. But the important things to note are: (a) some of the rules to follow (b) the importance of stops (c) the power of leverage, if things go your way!

31 comments:

h. lovil said...

Tim-want to hazard a guess as to how high this goes before a correction?

Wont hold you to it :)

bmbguy said...

Tim,

Just curious - that example SPX options quote page you showed still had a 1.00 spread. Do you use limit or market orders when buying the options?

ctkwtk said...

Regarding $ndx(qqqq). 1/03/2006, bear trap? 1/11/2006 bull trap? 1/03/2007, bear trap? 1/11/2007, bull trap? Or were both times just reaction highs after an extended run-up? (Or squeezes?) Oh, well,
"You can't tell till you bet".

Tim Knight said...

"Just curious - that example SPX options quote page you showed still had a 1.00 spread. Do you use limit or market orders when buying the options?"

The S&P is so high-priced, you just have to live with the big spread. A limit order is worth a try, but I usually just make it a market order, since the volume is really high and you have a fair chance at a fair price.

Leisa said...

Tim, thank you for this explanation.

Michael said...

"Well, it was another wreck of a day for da bears"

This bear is doing fine. As I commented on this site a couple of weeks ago, I may be bearish, but I will not fight the trend. I am neutral. I may not be making money in this move, but at least I'm not losing.

On the other hand, my short T-bond position is working nicely.

EddieFl said...

"TALK SOFTLY AND CARRY A BIG STICK OR BIG WALLET".


I remember watching some Cable news special on the mid-east tensions/issues a couple months ago. The one particularily memorable guy, a memeber of OPEC, who was mentioning and boasting of the power that OPEC had in the world, including over the US, in particularily over the US. He was boasting that they would control prices as they please and could and would use oil supplies as they please. They had supply at thier fingertips and will use for thier advantage.

At that momenent I realized that we have many fronts on this current War we are in. A very important front is the control of energy prices, supply and demand.
Beleive me, this War has many fronts and is a fight to the finish, to the end. And one more battlefeld is the financial markets and World energy supplies.

So, I love what has happend to Oil/crude prices the last two months, I am not much of a conspirator, but I have to beleive there are strong forces selling off/shorting that market. To show who carries the big stick, the Govt/Paulson are selling the hell out of it...... Who controls that market OPEC??/ Who can set prices??? Apprently they didnt see Oil at 52.00 coming at them.

How about taking the wind out of thier sails, How about answering some Opec thrash-talking with a swift kinck to the balls!!! They already cut productions last month, now they have called for an EMERGENCY MEETING IN Switzerland, where they will announce for more productions cuts.

So, they are cornering themselves,,, Lower productions, smaller supply with lower oil prices equal: less $$$= less influence= another Battle won for us.

No being supersitious or consipiratory, just some observations. After all we are still at War, that strecthes way beyond the streets of Baghdad.

toober said...

Thank you Tim for the peace and quiet that comes from the immanent demise of anon.

h. lovil said...

Hery Eddie- you seem to have forgotten Bush's buddies in the oil companies who have done very well out of the high oil price.

Every heard of the lee raymond (probably not!) just quit from Exxon and got 400 big ones as a parting gift.

That's separate from all the money he made while CEO.

Some guys are making big money from the 'war' and it isn't you or I.

http://www.abcnews.go.com/GMA/story?id=1841989

EddieFl said...

hlovil,

Yes, Lee Raymond, CEO of Exxon-Mobil for the last 20 yrs, heard about him 10 yrs ago,,, Yes he ran the most profitable company in the history of thw world for 20+ yrs, he deserves every dime he got,,

ass clown from Home Depot was there 6-7 yrs, Nardelli, did nothing, stock went nowhere, he may walk with 200mm..

I People alwasy get paid for production,, it is a very old story.

h. lovil said...

Well Eddie you have bought the Main stream media line....you think lee raymond did all this himself...all the big oil companies are wildly profitable..it has nothing to do with the CEO.

They lobby hard and well and they have a monopoly. Imagine if there was only four or five resturant chains!

You are clearly a patriot...but did you hear nay of the oil co execs giving 15% of the huge options, and bonuses they got from rising oil- into a fund for wounded servicemen???

Absoultely not.

Raymond's $400 Million would have paid for $130,000 for each dead servicemen's family.


No offense but you need to read more widely and don't swallow the media BS.

onewaystox said...

so much for peace & quiet

onewaystox said...

...but when ya think about, w/ that kind of money Mr. Raymond could spring for the Baptisms in Bahgdad ceremony himself

EddieFl said...

h.lovil

Well it did start out as many oil companies, and the bigger bought the smaller, just like the car industry. or the smaller just died off. At one time, in the early 1900's there was probably 20 something fledgling auto companies competing. I dont think Lee Raymond did it all himself, but he must of been a big component of them staying in first place, probably the biggest part of it.

I really dont see any CEO doing much for the war or any other philantropic issues, especially with thier own money, Except really, Bill and Melinda Gates and his money into medicine/healthcare.

I guess the point of my comment was that success/production/achievement is rewarded, sometimes to excess, sometimes to absurd levels, but Lee Raymond did not invent that game, he just played it very well. just like Jack Welch, Gates, Nardelli. To the successors come the spoils..

It is the beauty of free markets and capitalism.

onewaystox, this is just intelligent banter about current topics,,, much more civilized than the "annon" guys. Its all good...

trader said...

eddiefl,

What you are saying about Nardelli, the press was saying about Lay,Kowslowski,and Evers 4 yrz ago, and fortunatly 2 of those guys are getting a little bit of what they deserve and Lay got exactly what he deserved.All this "playin' the game" and right place/right time stuff is BS. Buffet's top manager made 10 Mil in'06 and thats with a bonus.And he don't issue stock options.And these dudes make much more impotant business decisions in a year than most CEO's ever encouter in a whole career.Buffet makes them held accountable everyday to "The SHAREHOLDERS".Thats the only way the 'free market enterprise' has any 'enterprise' in it.Gates and Buffet deserve their money because they created thier respective companies.They did the WetWork.I hope the HD shareholders class-action against Nardelli blocks every penny of his 210 Mil.So NO, it ain't all good, the shareholders are gettin' played.Fo' real.Know what I'm sayin'?

EddieFl said...

trader,

Yes, i know what you are saying. And i agree, NArdelli should get basic compensation, (which would still be in the millions) He has to have excellent skill-sets to even get to the level he was at GE and CEo of HOME Depot

In a perfect world he shouldnt get a dime of that walking away money, but we arent in a perfect world,, so we'll see soon enough what happens, .

I bet the 210mm, gets cut some, but he still walks with 100mm+ .

trader said...

You're probably right.Great problem to have when negotiating against yourself still leaves you with 100M.I'm now waiting for the Nachio criminal trial to begin soon.I used to be a fairly large Qwest shareholder so this one is close to home.Another A-hole in the right place at the right time with an ego 1000x the size of his talent and ethics.Here's to hoping ends up in Skillingville !

chanon said...

DOW needs to topper 12600 soon, if not small correction to 12200 is healthy.

DOW

AJ said...

Hi Tim,
Do you also look at the delta, gamma etc values while buying options? Do you make use of any software that would calculate the 'fair' price of that option?
Thanks,
AJ.

Health Affairs said...

IMO, Your first really decent post. Informative, instructive, and none of the BS you usually deliver. I for one welcome more posts like this that can actually teach something you obviously know about, instead of where the market is going. Leave that to the tarot card readers.

Thanks for the post.

Erich

Tim Knight said...

"IMO, Your first really decent post. Informative, instructive, and none of the BS you usually deliver."

Ummm, thanks, I guess.

PB said...

Yes, Erich! A big thank-you must also go out to you for enriching this comment board with your many insightful comments!

Looking forward to your next 'brilliant' post! --- NOT!!!

ODA125 said...

Tim,

Such refeshing tones of late coming form the comments. A wonderful way to start the new year! I have recently started a Options Blog to help give a little back for all that I have learned over the years. After reading your Options Trading process I thought I would also give you my blogsite to look at for comments. I really enjoy you view of the markets and also love Prophet Charts!!! The only one I use!!!

http://optionstheeasyway/blogspot.com

Take care - I hope you stop by sometime and leave a comment or two. BTW: I require a registered user to post so you will be quite comfortable there.

Regards,

ODA 125

z-stock said...

Tim,
Great article on options buying. I’ve been watching tv, again, to get my next idea. All the programs are saying, Tech rally this year, M&A Mondays, more this year than last year. Record amount of new IPO’s coming. Sounds like the steam is running out. I only have one trade suggestion. Calls on Mot. “till thurs. Reports earnings fri. a.m.
z-stock

PB said...

what the heck is going on with oil??

Fuckin saudi's won't defend it!

I bet there is a new 'big' field out there that they're keeping secret!

onewaystox said...

oil's going down to where it was pre-9/11...$27.62...don't you read the comments on this blog?

Actually, I heard a great interview on Bloomberg Radio yeasterday w/ an oil analyst (forgot his name. Bin, something. bindle? I don't know), he said that Saudi capex spending is set to explode. This will flood the mkt with supply. (Simple laws of economics says that if supply surges, prices go where?)

Also, about a month ago that we've only tapped into about 18% of the earth's total supply of discovered oil. That doesn't fit with the BS'ers out there saying that the wells are about to run dry.

onewaystox said...

Got it.

The interview was with analyst Ben Dell of Sanford Bernstein.

Click on the link & scroll down to find his interview from 1/9/07 (they must have replayed the one I heard yesterday). Enjoy.

http://www.bloomberg.com/media/podcast/ontheeconomy.html

PB said...

onewaystox ... you shd be running NASA you're so smart!

Oil is actually gonna be free you smart ass!!

EddieFl said...

Short BSC and GS. (PUTS) looking to hold for 2-3 days using 60minutes charts.

EddieFl said...

Short GS and BSC , (PUTS) on the 60 minute charts.

Those have been going up parabolic, Holding for 2-3 days.

PB said...

you wanna see parabolic?

take a look at WYNN and MGM!

What slow-down? Looks like overfed retards still have money to spend in Vegas!